Giselle Roux writes that it may be time to go back to the drawing board on asset allocation. 

It may not the time to make bold statements. We can test the water on which asset class is now relatively (noting that phrase) attractive, but inevitably hedge the bet on the possibility things will not be as expected.

Time to reconsider asset allocation

Valuations are in fresh air. We don’t know what company earnings will look like, nor is the direction of fixed income in any way certain, notwithstanding central bank buying.

The traditional approach is to adhere to the asset allocation as set up whenever the portfolio was most recently reviewed which for most would mean now adding to the share market. But before embarking on this path, what exactly is in the allocation?

Shares listed on the ASX are fairly straightforward, with a mish-mash of hedged/unhedged, big/small-cap and other variations. The reality is those correlations are high. Of course, unhedged global biased to defensive sectors may have lost less, but this is hardly a fundamentally driven decision to hedge against tail risk.

It’s the other allocations that may well determine the karma of any investor.

  • Equity-like that has now been exposed. Listed anything, given liquidity and questionable understanding of risk (for example recent LITs/LICs), high yield given its pecking order in the capital structure, high-risk unlisted debt, naturally due to its economic sensitivity and sector exposure, which was barely given a passing glance in pursuit of higher returns.
  • Credit, which has seen a big move in spreads. This may be a mark to market as the participants in this sector are hamstrung by their capacity to hold positions. Assuming defaults are manageable for investment grade, the total return outcome may be acceptable.
  • Alternatives, now proving their nomenclature. Early indications are that their performance is as wide as it can be. A few have tracked equity returns; some may do well, albeit this can after years of below-par results; a few have managed their risk positions by actively trading and some have just got it horribly wrong. The reality is that this asset segment can encompass so many possible risk positions.
  • Ah yes, if only we had had a decent weight of long (20 years plus) unhedged US Treasuries. Some may have a microcosm of such holdings hidden in a fixed income manager, yet realistically that would barely register. Australian private investors find it hard to like bonds.
  • Finally, commodities. Should we have had gold? Its performance has been roughly in line with bonds, hardly stellar and an expensive hold. How much of such as asset can one have in a portfolio for the ‘just in case’. Other commodities have largely been toasted.

A nuanced approach to rebalancing

Our naturally behavioural investment ethos is skewed towards returns rather than risk. In recent years most have pushed aside anything that does not match what has been a stellar share market, ignoring the probability many have not fully participated in equity returns by holding onto stale positions and not reinvesting dividends. Then most have added more equity risk in other asset classes. Fixed income is unlikely to be what the index suggests.

The challenge is to reconsider asset allocation. Re-establishing the boundaries that were premised for the portfolio, may not be the greatest decision. Instead, a nuanced approach is likely suitable.

Rethink equity-like risk. That is, any holdings where the correlation to equities/shares is high, not only based on recent data but logical scenarios. For example, economic risk in sectors, demographic segments, relationship to commodities and currencies, liquidity and pricing authenticity, amongst others.

This may highlight unintended weights to concentrated risks. Add to that any issues with liquidity, who else owns the positions, and re-read the small print of disclosures wrapped in cursory language that underplays the reality of what might happen.

Risk cannot be avoided, yet if we know what it is, it’s less frightening in the moment.

This article first appeared in The Inside Investor.